Types of finance in business
Should I be looking at finance for a startup?
There are five types of business finance that startups could consider. It is advisable that you understand each of these before you decide the type of finance that suits your needs. The three main types are:
- Self-funding – (Bootstrapping)
- Debt finance– money provided by an external lender, such as a bank, building society or credit union
- Equity finance – money sourced from within the business.
- Grants – funding and support programs from across governments to help your business grow.
- Lease Financing –
The first step is to work out how much you need, how the money will be used and how long it will last. The planning for this should be done by writing a Business Plan but remember, if your Business Plan shows that you cannot repay a loan then the probability is that you will not qualify for a loan in the first place.
If your idea is good then, even if you cannot quality for a loan, you may be able to attract Equity finance by offering shares in your company in return. This type of finance does not have to be repaid but you will give up some of your shares to attract investors.
When you have completed your Business Plan and know how much finance you need, it’s important to know your options. Knowing who to approach for finance can help you find the best finance option for your business.
Often called ‘bootstrapping’, self-funding is often the first step in seeking finance and involves funding purely through personal finances and revenue from the business. Investors and lenders will both expect some amount of self-funding before they agree to offer you finance.
What is Debt Financing?
Debt financing is borrowing money. There are many types of business loans including unofficial business scenarios where you take an equity loan on your home to finance the business or a relative gives you a loan to start it. There are also small-business loans and equipment or land loans for businesses. Most banks and credit unions offer some type of business financing, many with programs backed by the Small Business Administration standards and programs. There are also commercial lenders who specialize in business loans.
Most business loans are short-term loans, generally with terms from one to five years. Rates are high because of the risk of business failure and are often initiated by a business owner’s personal backing of the loan either with savings or property pledges. A property pledge might be a home or other large asset used in obtaining business loans.
The options for Debt finance are:
Banks, building societies and credit unions offer a range of finance products with both short and long-term finance solutions including business loans, lines of credit, overdraft services, invoice financing, equipment leases and asset financing. The issue for borrowers is in meeting the criteria set by these institutions which will often require security in the form of collateral e.g. your house, the need to have been in business and held a savings/operating account for a minimum period of time, a Profit and Loss Statement, Taxation Return and a Business Plan.
Similar in ways to Financial Institutions you and your business will need to qualify for a loan. In today’s environment it is wise to check if the Finance companies you are considering are registered and have a good reputation. There is a wide range of Finance companies offering short and long-term loans and each will have their own Terms and Conditions (TOCs), the interest rates charged will be different as will penalties for late payment or default.
If your need for money is related to purchasing goods and supplies that will in turn be used to generate profits then suppliers may offer trade credit that allows businesses to delay payment for goods. Trade credit terms often vary and may only go to businesses that have a reputable connection with the supplier.
Factoring is a financial transaction and a type of debtor finance in which a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount. A business will sometimes factor its receivable assets to meet its present and immediate cash needs. Forfaiting is a factoring arrangement used in international trade finance by exporters who wish to sell their receivables to a forfaiter. Factoring is commonly referred to as accounts receivable factoring, invoice factoring, and sometimes accounts receivable financing. Accounts receivable financing is a term more accurately used to describe a form of asset-based lending against accounts receivable.
In the United States, Factoring is not the same as invoice discounting (which is called an assignment of accounts receivable in American accounting – it is the sale of receivables, whereas invoice discounting (“assignment of accounts receivable” in American accounting) is a borrowing that involves the use of the accounts receivable assets as collateral for the loan. However, in some other markets, such as the UK, invoice discounting is considered to be a form of factoring, involving the “assignment of receivables”, that is included in official factoring statistics. It is therefore also not considered to be borrowing in the UK. In the UK the arrangement is usually confidential in that the debtor is not notified of the assignment of the receivable and the seller of the receivable collects the debt on behalf of the factor. In the UK, the main difference between factoring and invoice discounting is confidentiality. Scottish law differs from that of the rest of the UK, in that notification to the account debtor is required for the assignment to take place. The Scottish Law Commission is[ reviewing this position and seeks to propose reform by the end of 2017.
While factoring is a way to get quick access to cash, it can be quite expensive compared to traditional financing options.
Trade finance is an important external source of working capital finance. It is a form of short-term credit typically used by companies that export or import goods. It is relatively easy to secure short term finance, if you have a string trading record, secured against good or backed by an insurance policy.
Family or friends
If a friend or relative offers you a loan, it’s called a debt finance arrangement. If you decide on this option, carefully consider how this arrangement could affect your relationship.
What is Equity Financing?
Business owners may opt to sell corporate stock through private or public offerings. Depending on the amount of money being raised by selling shares of stock, regulatory entities may require public disclosures and filings. A public offering makes the company a traded entity on one of the stock exchanges.
Family or friends
Offering a partnership or share in your business to family or friends in return for equity is often an easy way of obtaining finance. However, consider this option carefully to ensure your relationship is not adversely affected.
Investors can contribute funds to your business in return for a share in your profits and equity. Investors such as business angels can also work in the business providing expertise or advice as well as funds.
Venture capitalists are usually large corporations that invest large sums in start-up businesses with the potential for high growth and large profits. They typically require a large controlling share of the business and often provide management or industry expertise.
Also known as an Initial Public Offering (IPO), floating on the stock market involves publicly offering shares to raise capital. This can be a more expensive and complex option and carries the risk of not raising the funds needed due to poor market conditions.
Some social media websites offer entrepreneurs a crowdfunding platform for their product prototypes or innovative projects. It involves setting a funding goal, providing project and budget details and inviting people to contribute to a startup capital pool.
Grants and assistance programs
In general, the governments do not provide finance for starting up or buying a business. However, you may be eligible for a grant, such as business expansion, research and development, innovation or exporting. Most countries, States and Regions have grants and assistance for startups.
Find grants, funding and support programs from across government to help your business grow and succeed! When searching for funding, keep in mind that you’ll generally need to meet certain criteria to be eligible, and that aside from funding assistance, many programs can help your business by building your skills and knowledge.
Businesses often fail because of a lack of funding for growth in areas of business equipment, operations and marketing. Financing a business is often overwhelming for business owners because there are many options to fund a company, each with different rules. Breaking business finance into three basic categories simplifies the process and organizes the financial needs of the business.
What is Lease Financing?
Lease options are popular for equipment, commercial automobiles and land. Leasing allows the business to keep autos and equipment up to date and new while lowering monthly payments compared to buying. A lease isn’t debt or equity financing. It is an agreement of use for a specified period. An example is leasing a box truck for three years, so the company has a delivery vehicle. After the three-year term, the company has the option to buy the truck or to return it and lease a newer model.